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Yola Edwards

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Betting on benchmarks

Yola Edwards

TORONTO (GlobeinvestorGOLD) — Technical analysis of the Dow Jones Industrial Average chart suggests that U.S. investors may be in for a very Merry Christmas indeed.

The Dow’s chart indicates it has finally broken out to new monthly high after having consolidated over the past 10 months. The flag pattern, a continuation formation, that has been traced out over the past 19 months suggests that the Dow is headed substantially higher over the next two years.

The 10-week simple moving average (MA) has crossed up above the 20-week MA, initiating a buy signal. Also, both the 10-week and 20-week MAs are turning up, indicating positive momentum.

The Dow has also passed the four-week rule, which is a simple breakout system and indicates a dominant cycle. The rule states that you should buy long whenever the price exceeds the highs of the preceding four full calendar weeks (conversely, you would go short if the price drops below the lows of the preceding four weeks). Cycle analysis suggests that underlying price movements are linked together in some fashion and the possibility of accurately forecasting future price movement is increased due to the existence of certain clearly identified recurring cycles. Currently the average is displaying a harmonic cycle. The principle of harmonicity, suggests that neighbouring waves are usually related by a small whole number, which is usually two.

Chart: DJIA over one year

Because the Dow has passed the four-week rule thus, you would anticipate that its next largest neighbouring cycle will be in the same direction. Applying harmonicity to this four-week cycle, by multiplying it by two, we would expect that over the next eight weeks the market will rally higher. Result: Christmas rally.

Chart: DJIA over three months

In the meantime, a short-term chart reveals that the Average reached an overbought level recently, as it traded up against the upper overbought Bollinger band before moving sideways for a few days and then dropping down to the 10-day MA. (Bollinger bands are technical tools measuring volatility and relative price levels over a specified period of time. The bands indicate overbought and oversold levels relative to a moving average.)

To alleviate the overbought condition, we might expect to see movement sideways to down. Any retreat should be short-lived, however, as the 20-day MA has just crossed the 200-day MA, issuing another buy signal, and the 41-day MA is following closely behind. A crossing of the 41-day MA over the 200-day MA would strengthen the support under the market and a virtual upside explosion could follow, so buying the dips, if any appear, seems to be in order.

The short-term chart reveals that the near-term upper Bollinger band suggests 10,800 would be the next upside target. If the Dow is able to continue moving higher, the upper short-term band could expand even further yet.

The longer term is even brighter. If we look back at the longer-term Dow chart we see a flag pattern has been traced out. This type of pattern is just a pause in a dynamic market as the index interrupts its advance to catch its breath before running off in the same direction. To measure the extent of the next expected move you would add the length of the flagpole about 3,234 points, to the breakout point. In the case at hand, we should expect the target measurement to reach approximately 13,547, at a minimum, over the next two years, as that is how long it has taken the pattern to form. Also, expect the new rally to mirror the slope of the previous flagpole, in which case you should expect a very fast and positive market in the New Year.

How do we take advantage of all of this good news then? Buying Diamonds would be one option. Diamonds are the colloquial name for Diamonds Trust Series I Shares [DIA]. The exchange-traded fund is structured as a unit investment trust and is simply an indexed investment that tracks the Dow Jones Industrial Average.

Chart: Diamonds Trust Series I Shares over one year

As you can see, the Diamonds chart is a mirror image of the Dow chart. However, it trades at 1/100 of the Dow Jones Industrial Average. Just like the Dow, it too is overbought. To alleviate the condition, Diamonds may pull back to test the breakout at about the 103.50 point, which is now also a support offered by the upper trend line of the flag pattern. The flag pattern suggests a target of approximately 135.49 over the next two years, or approximately a 30-per-cent return on investment from current levels over two years.

Diamonds would be suitable for investors with U.S. funds at their disposal, but they will present a currency exchange problem for investors who plan to convert Canadian funds to U.S. dollars, as previous technical analysis of the Canadian dollar suggests it will rise to approximately 87 cents (U.S.) over the next two years. If my analysis of both the Canadian dollar and the Dow are on target, then investors who convert funds will likely have their return on investment reduced by 3.6% for a possible return of 26.30% over the same period.

Regardless, it looks like the market and investors’ returns on the Dow will be sparkling over the next two years.

Yola Edwards is a contributing writer and technical analyst for Bell Globemedia Interactive, providing options and technical analysis research on a variety of North American equities.

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